Changes In Securities Law: Two Cases From 2014 And One To Watch

Some lesser known securities cases this year have changed things up, while the case everyone watched had little practical effect. You may well remember the hype surrounding at least one securities case this year, Halliburton Co. v. Erica P. John Fund, Inc. (“Halliburton II”), 134 S. Ct. 2398 (2014). The case gave the Supreme Court the opportunity to overrule the fraud-on-the-market presumption of reliance, established in 1988 in Basic v. Levinson. For shareholders and attorneys practicing in the securities litigation field, the potential impact on class action securities cases was striking. As it turns out, the case barely had an impact. Instead of overruling or altering the Basic rule, the Supreme Court simply allowed evidence of the absence of market effect to be admitted at the class certification stage where previously the evidence was not considered until summary judgment.

A forthcoming Supreme Court decision in a different, less-heralded case – Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund – is the one to watch for this year. Despite the lack of fanfare, Omnicare likely will have the greatest practical impact of any Supreme Court securities decision since the Court’s 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). Although this case only involves Section 11, it poses a fundamental question: What causes an opinion or belief to be a “false statement of material fact?” The Court’s answer will affect the standards of pleading and proof for statements of opinion under other liability provisions of the federal securities laws, including Section 10(b), which likewise prohibit “untrue” or “false” statements of “material fact.” Omnicare concerns what makes a statement of opinion false; whether it is an objective or subjective standard. The Sixth Circuit held that a showing of so-called “objective falsity” alone was sufficient to demonstrate falsity in a claim filed under Section 11 of the Securities Act – in other words, that an opinion could be false even if was genuinely believed, if it was later concluded that the opinion was somehow “incorrect.”

Analysts, those “in the know,” are split on whether the Court is likely to reverse or affirm the Sixth Circuit’s holding, but most seem to expect a middle ground. Bear in mind that the case was only at the Motion to Dismiss stage. So, while the Court will likely provide guidance on what constitutes “reasonable basis,” even if the Court does affirm, the theory will still need to be tested at summary judgment and trial. Potentially, the Court could send the case back and require further pleading on what makes Omnicare’s statements false and without a reasonable basis – this is the most likely result. The Court could also, of course, completely surprise everyone and fully reverse the Sixth Circuit, creating a new standard. Either way, the case is one to watch.

On June 4, 2014, in SEC v. Citigroup, 752 F.3d 285 (2d Cir. 2014), the Second Circuit held that Judge Rakoff abused his discretion in refusing to approve a proposed settlement between the Securities Exchange Commission (SEC) and Citigroup that did not require Citigroup to admit the truth of the SEC’s allegations. Certain events occurred during the pendency of the appeal, however, that overshadowed the case itself. In 2012, the SEC and Citigroup settled the SEC’s investigation of Citigroup’s marketing of collateralized debt obligations. In connection with the settlement, the SEC filed a complaint alleging non-scienter violations of the Securities Act.

The same day, the SEC also filed a proposed consent judgment, enjoining violations of the law, ordering business reforms, and requiring the company to pay $285 million. As part of the consent judgment, Citigroup did not admit or deny the complaint’s allegations. Judge Rakoff held a hearing to determine “whether the proposed judgment is fair, reasonable, adequate, and in the public interest.” In advance, the court posed nine questions, which the parties answered in detail. Judge Rakoff then rejected the consent judgment resting, in part, on the court’s determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest because the public would not know the “truth in a matter of obvious public importance,” and private litigants would not be able to use the consent judgment to pursue claims because it would have “no evidentiary value and no collateral estoppel effect”.

The SEC and Citigroup appealed. While the matter was on appeal, the SEC changed its policy to require admissions in settlements “in certain cases,” and other federal judges followed Judge Rakoff’s lead and required admissions in SEC settlements. Because of the SEC’s change in policy, many people deemed the appeal unimportant. Despite the change in SEC policy, the extent to which the SEC insists on admissions will depend on the amount of deference it receives from reviewing courts – which was the issue before the Second Circuit. The Second Circuit’s holding, that the SEC has the “exclusive right” to decide on the charges, and that the SEC’s decision about whether the settlement is in the public interest “merits significant deference,” reasserted SEC’s authority to make those decisions. The decision grants the Commission a great amount of deference when settling its cases.

This case is important because of the potential to cause scrutiny of the protections of the Private Securities Litigation Reform Act (PSLRA). Some believe the greatest risk to the Reform Act’s protections has always been legislative backlash over a perception that the Reform Act is unfair to investors. The Reform Act’s heavy pleading burdens have caused Plaintiffs’ counsel to seek out former employees and others to provide internal information, i.e. Confidential Witnesses. The investigative process is often difficult and is ethically tricky, and the information it generates can be lousy. Information can be misunderstood, misinterpreted, and/or misconstrued by the time it is conveyed from one person to the next. To further complicate matters, CWs sometimes recant or even deny that they made the statements on which Plaintiffs rely.

Judge Rakoff seemed to call for such reform in his post-dismissal order in the separate, yet similar for its potential to call into doubt the Reform Act, Lockheed matter:

The sole purpose of this memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led Plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both Plaintiffs and Defendants. It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn Plaintiffs’ counsel into corporate ‘private eyes’ who would entice naïve or disgruntled employees into gossip sessions that might help support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.